Zou Chuanwei: The impact of blockchain on payment systems

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Foreword: Blockchain has been closely related to payment systems from the very beginning of its development. Satoshi Nakamoto invented the blockchain, hoping to turn Bitcoin into a peer-to-peer electronic cash system. Ripple and Circle carried out early attempts to make cross-border payments based on blockchain. The Libra project claims to build a simple global currency based on the blockchain and a financial infrastructure that empowers billions of people. Wholesale central bank digital currency (CBDC) projects such as Ubin (Singapore), Jasper (Canada), Stella (Europe and Japan), and LionRock (Hong Kong) have fully tested representative blockchain platforms. PayPal launched bitcoin trading and payment services.

Due to space limitations, this article focuses on discussing the impact of blockchain on the payment system from the perspectives of stablecoins and CBDC, involving nine issues: 1. Currency and payment systems; 2. Digital currency classification; 3. Blockchain as finance Infrastructure; 4. Stable currency; 5. Central bank digital currency; 6. Wholesale payment; 7. Retail payment; 8. Cross-border payment; 9. Issues to be studied.

Currency and payment system

To discuss the impact of blockchain on payment systems, one needs to understand mainstream currencies and payment systems.

First, in addition to cash, currency exists in the bank account system, and the bank account system is hierarchical. The top level is the central bank account. Commercial banks open accounts with the central bank. Individuals, enterprises and government departments open accounts in commercial banks. Non-bank payment institutions represented by Alipay and WeChat Pay have established payment accounts, which are closely coupled with commercial bank accounts. The above accounts are all real-named.

Second, currencies are also stratified. The top level is the central bank currency, which represents the credit of the central bank. Central bank currency mainly includes cash and deposit reserves. Cash is oriented to the general public, does not rely on the bank account system, and corresponds to M0 in currency classification. The deposit reserve is for commercial banks. In any modern society, most currency (measured by M2) is the deposit currency of commercial banks, representing the credit of commercial banks. The deposit reserve is not included in the M1 or M2 statistics because it is both the central bank’s liabilities and the commercial bank’s assets.

Third, the payment system. Payment is divided into wholesale payment and retail payment. Wholesale payments occur between financial institutions and between financial institutions and the central bank. Retail payment is related to the purchase of goods and services by consumers and commercial institutions, and occurs between financial institutions and users.

Whether it is wholesale payment or retail payment, there are front-end and back-end. For example, the front end uses WeChat Pay to scan a QR code to initiate payment. The back-end includes clearing and settlement, which is the link for processing real money.

There are three main settlement methods in the payment system. The first is real-time full settlement (ie RTGS), which refers to the full settlement of payment instructions one by one, which is highly efficient and reduces the credit risk involved in the payment, but requires high liquidity. The second is the delayed net settlement, which refers to the net settlement after the payment instruction is netted, which can save liquidity, but will generate settlement risk and slightly lower efficiency. The third is a mixed mode of the first two. In my country, the large-value payment system of the People’s Bank of China uses real-time full settlement, while the small-value payment system uses delayed net settlement.

Fourth, the payment in the bank account system is reflected in the reduction of the corresponding amount from the payer’s account balance, while the corresponding amount is added to the recipient’s account balance. If the accounts of the payer and the payee are not in the same account management agency (such as a commercial bank), then this payment will trigger a transaction between the two account management agencies, and this needs to be adjusted by their higher-level account management Institutions (such as the central bank) account balances. The above are the most important dynamic features of the bank account system.

Fifth, the flow of funds in cross-border payments is carried out through the bank account system, especially through correspondent bank accounts. The information flow in cross-border payments is carried out through the SWIFT messaging system. The reliance of cross-border payment on the bank account system and the separation of capital flow and information flow are the keys to understanding blockchain to improve cross-border payments.

Digital currency classification

This article focuses on digital currencies that can effectively undertake the basic functions of currency (transaction medium, accounting unit, and value storage).

This direction is difficult to establish. When the market price is lower than the anchor price, the algorithmic central bank stable currency will issue discount bonds to recover the stable currency. But if the market loses confidence in stablecoins, it will be difficult to issue bonds. Even if it is issued, the bond issue price will be greatly discounted to the face value, reducing the effect of recovering liquidity. And when the bonds mature, there will be a net release of liquidity.

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Blockchain as a financial infrastructure

Mainstream stable currency.

Tokenization of legal tender has three core characteristics. First, use Token to represent legal tender, and Token transaction to represent legal tender payment. Second, Token is issued based on a 1:1 legal currency reserve and will not be accompanied by new currency creation. Third, the Token issuer ensures that the Token issued outside has sufficient legal currency reserves as support, and ensures the 1:1 two-way convertibility between Token and legal currency. Fourth, the two-way exchange between Token and legal tender involves the coordination between the bank account system and the Token ledger system.

According to the nature of the Token issuing agency and the legal currency reserve depository, the Tokenization of legal currency can be divided into three situations (Table 1):

Table 1: Classification of legal tender tokenization

When the central bank’s digital currency has a well-developed payment system, why discuss the tokenization of legal tender? What has changed in the application of blockchain in the payment system, and what hasn’t changed?

It is said that the blockchain represents the biggest bookkeeping revolution after double-entry bookkeeping. This statement is specious. The concepts of assets, liabilities, and cash flow have a solid foundation in economics, law, and accounting. The evolution of technology has given new forms and recording methods for assets, liabilities, and cash flows, and accounting has also moved from manual to computerized accounting. But these will not affect the principle of double-entry bookkeeping, and blockchain is no exception. Not only that, double-entry bookkeeping can provide sophisticated analysis tools for activities like DeFi endogenous to the blockchain.

What the blockchain changes is the recording of property rights and transactions.

Stablecoin

Stablecoins based on non-full legal currency reserves are feasible under normal conditions and have currency creation and seigniorage. The goal of the legal currency reserve is to ensure that stable currency issuers can pay legal currency when users redeem stable currency. Full reserve is the most direct and effective way to achieve full redemption of stablecoins. But according to the theorem of large numbers, users of stablecoins cannot all redeem them at the same time. In theory, there is no need to hold 100% of the reserves to meet the demand for stablecoin redemption most of the time. At this time, the newly issued stablecoins are not supported by legal currency reserves, but they also meet the needs of stablecoin users, which is equivalent to issuing a part of stablecoins “out of thin air”. These stablecoins have purchasing power in the real world, which corresponds to the concept of seigniorage.

For the monetary authorities, a legal and compliant single currency stable currency is mainly a payment tool, there will be no currency creation, no impact on monetary sovereignty, and financial risks are controllable. Because of the open characteristics of the blockchain, a single currency stable currency will expand the use of currencies abroad, thereby strengthening the position of a strong currency and eroding the position of a weak currency. For example, some economically and politically unstable countries have already experienced a “dollarization” trend, and legally compliant USD stablecoins will further strengthen this trend.

The supervision of single currency stablecoins in major countries will become more and more perfect, which has been fully reflected in the compliance framework of Libra 2.0. Recently, the Financial Stability Board made regulatory recommendations for global stablecoins. The European Commission formally proposed a regulatory framework for crypto assets and stablecoins. The Office of the Comptroller of the Currency allowed the Federal Chartered Bank of the United States and the Federal Reserve to hold reserves for stablecoin issuers.

The implementation of a basket of currency stablecoins in the form of Libra 1.0 faces problems such as rebalancing the currency basket and the lack of supervision bodies for the adequacy of the basket of legal currency reserves, which is not feasible. In particular, the adequacy of the legal currency reserve of stable currencies can only be monitored by currency, and the adequacy of multi-currency legal currency reserves does not have a suitable international regulatory body. This is an important reason for Libra to switch from 1.0 to 2.0.

CBDC is central bank currency in digital form. Central bank currency mainly includes cash and deposit reserves. CBDC replaces cash (M0), corresponding to retail CBDC; CBDC replaces deposit reserve, corresponding to wholesale CBDC.

CBDC will not move in the direction of “replacement of M1 or M2”. First of all, the main part of M1 and M2 is the deposit currency of commercial banks, which represents the credit of commercial banks. CBDC represents the credit of the central bank, and “CBDC replacing M1 or M2” logically faces many obstacles. Second, the payment system related to the deposit currency of commercial banks is built on the bank account system, which is highly efficient and safe. Transforming into a Token ledger system is of little significance to the improvement of the payment system. Third, CBDC replaces a large proportion of commercial bank deposit currencies, which is actually a situation that the central bank should try to avoid in the CBDC design, because it will affect the deposit stability and credit intermediary functions of commercial banks.

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CBDC issuance is generally based on on-demand exchange (“100% deposit reserve basis issuance”), rather than expanded issuance. In other words, the initiative of CBDC issuance and redemption lies with commercial banks rather than central banks, but it is fundamentally driven by user needs. Commercial banks use deposit reserves deposited in the central bank to exchange CBDC with the central bank according to user needs, which constitutes the issuance of CBDC. Conversely, commercial banks redeem CBDC from the central bank and exchange deposit reserves according to user needs, which constitutes a redemption of CBDC. Because of this arrangement, the issuance and redemption of CBDC does not affect the central bank’s total currency, and its impact on inflation is neutral.

CBDC projects generally follow the “central bank-commercial bank” binary model, that is, there are two links in the CBDC program: wholesale and retail. The wholesale link mainly refers to the issuance and redemption of CBDC, and the participants are central banks and commercial banks. The retail link refers to CBDC deposit, withdrawal and payment. The participants are commercial banks and users.

Wholesale payment

An important goal of wholesale CBDC is to transform the existing real-time full settlement system (RTGS), represented by Ubin, Jasper, Stella and LionRock.

Wholesale CBDC mainly involves central banks and commercial banks, and is an application at the level of financial infrastructure. The targeted scenarios are relatively clear and do not involve complicated monetary and financial issues. The experiment of wholesale CBDC is ahead of retail CBDC.

The conclusions of the wholesale CBDC test are relatively consistent. First, the wholesale CBDC can support RTGS, and the liquidity saving mechanism can be implemented in a decentralized manner (ie through smart contracts). Second, the wholesale CBDC can support tokenized securities transactions, and in a decentralized environment, it can achieve single-book coupon payment (DvP), but the hash time lock (HTLC) that cross-ledger DvP relies on has certain defects. Third, wholesale CBDC is applied to the logic of synchronous cross-border transfer (PvP) and applied to tokenized securities transactions. The middleman model is the mainstream cross-chain solution.

Cross-chain is a core problem to be solved by wholesale CBDC. However, cross-chain is not entirely a technical problem, and economic solutions with a certain degree of centralization are getting more and more attention. For example, the LionRock project of the Hong Kong Monetary Authority and the Inthanon of the Central Bank of Thailand have also conducted simultaneous cross-border transfer experiments. The scheme they adopted is called the “corridor network”, which essentially “maps” the CBDCs of the two currencies into the same ledger system (that is, issuing CBDC certificates on the “corridor network” based on 100% of the CBDC reserves), making the same ledger The system supports multiple CBDCs.

Retail payment

Retail CBDC is expected to achieve cash-like security and the convenience of peer-to-peer payment. The main goal of the central bank to develop retail CBDC is to use the openness of the CBDC system to promote financial inclusion. The fine-scale payment data provided by the CBDC system helps macroeconomic decision-making. In the context of the new crown epidemic, CBDC will also provide an effective tool for the government to pay individuals for assistance.

The relationship between retail CBDC and cash usage is more subtle. On the one hand, in countries that use more cash, the central bank hopes to replace cash with CBDC, which will not only reduce the costs associated with the cash system, but also alleviate the impact of the untraceability of cash on money laundering, terrorist financing, and tax evasion. On the other hand, in countries where the use of cash is gradually decreasing, the central bank hopes that the public will hold central bank currency in the form of CBDC, which not only promotes the security, efficiency and robustness of the payment system, but also eases the protection and privacy protection of users after payment institutions become larger. The impact of fair competition in the market. Our country belongs to the latter situation.

The retail CBDC design scheme needs to consider the following issues. First, the impact of retail CBDC on financial stability and monetary policy. Second, the payment and settlement arrangements for retail CBDC. Third, retail CBDCs need to take into account the three requirements of openness and inclusiveness, limited anonymity, and regulatory compliance. Fourth, how to play the role of the private sector in the application and promotion of retail CBDC. Fifth, how to hold and use retail CBDC by foreign individuals and institutions. There is no universally accepted answer to these questions.

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It should be noted that the current performance and security of blockchain technology are not enough to support large-scale retail CBDC applications. However, retail CBDC, as a replacement or upgrade of cash, has features such as openness, controllable anonymity, peer-to-peer transactions, transaction-based settlement, and offline payment, which are both cash-like and beyond cash. Essentially, they cannot be separated from the absorption of blockchain technology. .

Cross-border payment

Both retail CBDC and wholesale CBDC can be used to improve cross-border payments, and both have the characteristics of transaction-as-settlement, capital flow and information flow, but they have different focuses.

Retail CBDC is used for cross-border point-to-point payments, and can be completely independent of the intermediary function of commercial banks. In the retail CBDC system, from a purely technical point of view, there is no distinction between domestic and overseas wallets, and no distinction between onshore, offshore and cross-border payments. However, the central bank’s system architecture and technical capabilities are very demanding. In a certain sense, it can even be said that retail CBDC is used for cross-border point-to-point payment, and Bitcoin is used for cross-border point-to-point payment, which is logically similar.

Wholesale CBDCs are used for cross-border payments and retain the intermediary functions of commercial banks, mainly to improve the current agency banking mechanism.

Questions to be studied

Since Facebook took the lead in proposing the Libra project, the innovation and supervision of stablecoins and CBDC has accelerated globally, greatly enriching our understanding of how blockchain will affect the payment system. Looking to the future, what are the issues that need to be studied in this field, and which issues will determine the direction of development in this field? This article raises eight questions.

First, the supervision of single currency stablecoins based on insufficient reserves. Single currency stablecoins based on non-full reserves provide seigniorage for issuers, but along with currency creation, it affects the country’s monetary sovereignty, and it is difficult to deal with concentrated large redemptions, which is a potential source of financial risk.

Second, the application of single currency stablecoins outside of crypto asset exchanges. Can single currency stablecoins move towards mainstream users and mainstream payment scenarios, providing user experiences similar to PayPal, Alipay, and WeChat payment? This will be the ultimate test of stablecoins.

Third, the prospect of a basket of currency stablecoins as cross-border settlement currencies. Libra 2.0 uses a basket of currency stablecoins as an efficient cross-border settlement currency, but how big is the demand in this regard? A basket of currency stablecoins represents the latest effort of mankind to build a super-sovereign currency. The Special Drawing Rights (SDR) of the International Monetary Fund, as a super-sovereign currency, is limited to countries (to G). It has a valuable storage function, but it does not have the function of a medium of transaction and a unit of account. Can a basket of currency stablecoins be extended to the to B and to C scenarios, and can they develop the functions of transaction media and accounting units?

Fourth, it supports DvP and PvP cross-chain technology. Pure cross-chain technology may not develop so fast, and the role of economic solutions with a certain degree of centralization represented by the “corridor network” will become more important.

Fifth, the clearing and settlement arrangement of retail CBDC. If retail CBDC transactions of individuals and institutions (including commercial banks) are reflected in the central bank’s CBDC system update in the first time, it is equivalent to the central bank’s provision of real-time full settlement services to the public, with commercial banks and bank card clearing organizations None of it.

Sixth, the status of non-bank payment institutions in the retail CBDC ecosystem. This question has the following dimensions: Can non-bank payment institutions trade with the central bank to obtain a retail CBDC? Can retail CBDC redemption and redemption services be provided to users? Can you provide retail CBDC wallet services to users? Can you accept users’ recharge with retail CBDC? Can a non-bank payment institution app be associated with a retail CBDC wallet (payment is initiated by a non-bank payment institution app, but the payment is through the retail CBDC wallet)?

Seventh, whether to use wholesale CBDC or retail CBDC for cross-border payment. In the future, whether to choose two paths is still inconclusive based on experiments in various countries.

Eighth, the programmability of stablecoins and CBDC. Stablecoins and CBDCs are naturally programmable and can support rich and intelligent application scenarios, making finance move towards intelligence. However, “CBDC + smart contract” may enable CBDC to assume social and economic functions in addition to the basic functions of currency (transaction medium, unit of account, and value storage), thereby affecting the currency’s versatility and liquidity. It is expected that “Stablecoin + Smart Contract” will precede “CBDC + Smart Contract”. The application of the programmability of crypto assets in the DeFi field will provide a useful reference for “stable coins + smart contracts” and “CBDC + smart contracts”.